Henry’s Hierarchy of Financial Goals

When it comes to your financial life, there are a lot of things pulling at your wallet. That is why it is important to understand your financial goals and their relative priority to one another. For this reason, today I wanted to do a deeper dive into common financial goals and my opinion on where they should be prioritized in the overall scheme of your financial life. I created the visual below to outline common financial goals and their priority. I also have taken a deeper dive into each goal in further detail.

Tier 1: The Basics

Tier 1 of my financial hierarchy encompasses the basics including an emergency fund, retirement contribution up to the employer match and elimination of high interest credit card debt. As a HENRY, there is no reason why you should not have the basics covered. If you do not, you are simply treading water and running the risk your life will be derailed by an unexpected job loss or financial emergency. Lets discuss Tier 1 in more detail in order of priority.

1A: ~ 1 Month Emergency Fund

A one month emergency fund is absolutely non-negotiable. If you cannot cover your auto or medical deductibles and/or a small basic emergency, you are asking for trouble. According to a survey conducted by Bankrate in early 2019 [1], only 40% of Americans are able to cover an unexpected $1,000 expense. Only 40%! Think about that for a minute. An unexpected emergency costing $1,000 would be catastrophic for 60% of Americans. This is the case because a lot of people live paycheck to paycheck. As a HENRY, you should NOT be living paycheck to paycheck. If you cannot cover deductibles and/or a small basic emergency, you have a major problem and you should fix it now.

1B: Retirement Contribution (Employer Match)

If you have an employer sponsored retirement plan like a 401k, there is a very good chance your employer matches your contributions. Most employers choose to participate in a safe harbor 401k plan with many plans being based upon an employee contribution. Typical plans will match 100% of the first 3% that you as the employee defer and then 50% of the next 2% you defer (4% in total). This is essentially free money. If I offered your $3000 – $4,000 cash with no risk would you take it? Of course you would! If you make $100K and choose not to contribute to your 401K plan up to the employer match, you are essentially saying no thank you to free money. For this reason, you should always contribute enough to your retirement accounts to take advantage of your full employer match.

1C: Pay Off High Interest Debt

Based upon NerdWallet’s annual analysis of U.S. household debt [2], the average U.S. household with revolving credit card debt has an estimated balance of $6,489 costing and average of $1,162 in annual interest. 10% of people surveyed in the study also indicated it will take them longer than 10 years to pay off their balance. The chart below shows a breakdown of U.S. household debt by total and average amount per household as of March 2020. 

As someone in the pursuit of financial independence, you SHOULD NOT have high interest debt including credit card debt. Your income affords you the ability to cover your expenses without going into credit card debt. If you cannot, your expenses are too high and you need to re-evaluate your spending. If you already have high interest debt because of past mistakes, you should be able to create the extra cashflow necessary to pay it off. You can’t build wealth if you continually carry high interest debt. In short, it will be very difficult, if not impossible, to achieve financial independence if you consistently have high interest debt, including credit card debt. The average credit card interest rate as of August 2020 is 16.03%. [3] 16.03%! That is highway robbery! I wrote previously about the 8th wonder of the world in compound interest. Carrying high interest credit card debt makes compound interest work against you instead of for you. If you currently have high interest debt including credit card debt, you should treat it like an emergency and work to pay it off immediately.

Note: Many financial advisors and well known figures in the personal finance space recommend you do not utilize credit cards because of their high interest and potential to make you spend more. I personally use credit cards for most of my spending (and pay them off monthly) and believe they are a valuable tool if utilized responsibly. There will be more to come in future posts on this front.

1D: ~ 3 – 6 Month Emergency Fund

My last post was about the importance of an emergency fund, so I will point you here to get into more detail on the subject. I did want to throw in the chart below as a reference point. [4] Personal Capital did a study of savings balances of Americans stratified by age. The study looked at liquid savings vehicles like saving accounts, CDs and money market accounts. It did not include spousal accounts, checking, retirement, brokerage, etc. As you can see, average Americans do not have a whole lot saved.

As a HENRY, you should strive to be more than average with your finances. With an above average income and likely above average expenses, a 3 – 6 month emergency reserve is not only possible but essential. 

Tier 2: Saving/Investing 

Tier 2 of my financial hierarchy encompasses long term saving and investing in the form of Roth IRAs, HSAs and maximizing retirement accounts, as well as the pre-payment of non-mortgage debt. Unlike Tier 1, Tier 2 is very nuanced and there is a lot of room for variability from person to person.  With a quick Google search you will find millions of blog posts and articles discussing paying down student loans vs. investing, paying off car loans vs. contributing the maximum to retirement accounts, etc. It is important to understand that it does not have to be a binary decision when choosing which financial goals to pursue in this space. You can choose to focus on one area or you can choose to focus on multiple areas simultaneously. The important thing is to consider all applicable factors in order to make an informed decision that works for you and allows you to achieve your goals.

2A: Maximum Contributions to Retirement Accounts

Once you have a solid emergency reserve, take advantage of your employer’s match and ensure you do not carry high interest credit card debt, you should consider contributing the maximum for all available retirement vehicles. The investment company, Vanguard, does an analysis of their retirement accounts to include average and median 401k balances by age as well as average and median balances by income. [5] The first chart below shows the average and median amount people have saved for retirement by age while the second chart stratifies by annual income.

The charts above are only intended to be reference points. If you seek financial independence, especially earlier in life, then you cannot be average. You must not be average. You must save and invest more. One way to do so is to contribute the maximum to available tax advantaged retirement accounts. I will write future posts getting into much more detail about the various retirement accounts, withdrawal strategies to include withdrawing money prior to traditional retirement age, etc. For today’s post, I simply want to highlight a couple of common misconceptions.

• Misconception #1: I can’t access my tax-advantaged retirement contributions prior to traditional retirement age.

Anyone who tells you this is either misleading you or simply misinformed. Either way, they are wrong. There are numerous ways to access tax-advantaged accounts prior to traditional retirement age including Roth Conversions. If you are unfamiliar with this strategy, you can get a quick overview on Investopedia here to get a little more information. Again, I plan to write much more about these withdrawal strategies in the future, but I think it is important to point out for this post that you can access your retirement accounts early with a little planning.

• Misconception #2: I should invest in Roth vehicles or a taxable brokerage account instead of tax-advantaged accounts because taxes will likely be higher in retirement.

No one really knows what taxes will be in the future. It is true that taxes may in fact be higher when you choose to withdraw funds from your investment accounts. There are a lot of data points including the ballooning national debt, propensity to run a national annual budge deficit and unsustainable social programs including Medicare and Social Security that would lead one to reasonably conclude that tax rates will be higher in the years to come. However, there is an important factor that many do not consider. Once you begin to withdraw from your investment accounts, you have MUCH more control over your tax rate. This control is driven by the earned income side of the equation. Once you choose to stop working, work less or otherwise reduce your income in the pursuit of another passion, you reduce your earned income. This gives you increased flexibility when drawing from your investment assets which allows you manipulate tax rates in place at the time to withdraw money advantageously. In short, yes taxes may be higher, but you have greater control of your tax rate when your income is not driven solely by W2/1099 income.

• Misconception #3: I should not contribute the maximum to tax-advantaged retirement vehicles in order to avoid a retirement “tax bomb” due to large required minimum distributions (RMDs).

As I noted above, you have increased flexibility to control your tax rate when you stop working or at least drastically reduce the earned income side of the equation. This is especially true if you reach financial independence earlier in life because you may work less and begin drawing down your retirement accounts over a period of time prior to reaching the age where RMDs are required (currently 72 in 2020). I do want to be clear here. For anyone seeking to achieve financial independence, diversification of assets is still important. In addition, as a HENRY, it is also very possible to save multiple 7 figures in tax-advantaged accounts which can create a tax bomb due to large RMDs. For this reason, I think this is definitely something to be cognizant of when saving and planning. However, it is likely something you need to consider once you begin to build considerable assets in traditional retirement vehicles. 

In conclusion, I think you should take advantage of all tax-advantaged vehicles if you are in a higher tax bracket. This will allow you to take the tax break now and will likely increase your flexibility in the future when choosing how and when to withdraw from these accounts. This is another area where there are a lot of varying opinions, and ultimately none of them including mine are 100% right or wrong. Once again, you have to consider all applicable factors in order to make an informed decision that works for you and allows you to achieve your goals.

2B: Roth IRA and HSA

Diversification of investment vehicles is an important factor to consider because it does allow for even greater control of your tax rate once you are financially independent and begin to withdraw from your investment assets. As I said above, I am a proponent of higher earners taking the tax deduction now by contributing to traditional retirement accounts including your 401k/403b/457b. However, you can and should also take advantage of a Roth Individual Retirement Account (IRA) and Health Savings Account (HSA).

Roth IRA: The annual contribution limit for an Individual Retirement Account (IRA) in 2020 is $6,000 of $7,000 if you are age 50 and older. Contrary to what some believe, you can contribute to both a 401k and an IRA. As a HENRY, you likely will not qualify for a tax deduction based upon traditional IRA deduction limits. For this reason, I suggest you do the necessary research to take advantage of a Roth IRA. A Roth IRA contribution does not allow you to take a tax deduction in the current tax year. However, your contributions will grow completely tax free. You heard me right. Completely tax free. You can contribute the $6,000/$7,000 and when you withdraw from the account you will pay no taxes on the contribution since you were already taxed and no taxes on the earnings. Thank you Uncle Sam! For this reason, this can be a valuable tool for anyone including a HENRY. Before considering a Roth IRA, make sure you do your research and understand all the rules.

Note: The Roth IRA income limits in 2020 begin at $196,000 modified adjusted gross income (MAGI) for married filing jointly with a full phase out at $206,000. For single filers, the range is $124,000 – $139,000. Even if you do not qualify for a direct Roth IRA contribution based upon your income, you can still contribute through a Roth conversion often referred to as a Backdoor Roth IRA. I will write a future post on the mechanics of this in detail. However, for today’s post, it is important to understand that you can utilize this saving tool regardless of your income.

HSA: A Health Savings Account (HSA) is a tax-advantaged account specifically for individuals with high-deductible health plans (HDHPs). The annual contribution limit for a HSA in 2020 is $3,550 for self-only and $7,100 for families with a catch-up contribution of $1,000 for individuals 55 or older. Many people utilize these to save for qualified medical expenses within any given calendar year. However, for a HENRY with access to a HSA, this can be a valuable investment tool since it is triple tax efficient. Your contributions are tax deductible, your earnings grow tax free and your withdrawals can also be tax free if they are utilized for qualified medical expenses. The secret is understanding all the HSA rules. Specifically, you can invest in an HSA and not withdraw the funds for years or even decades down the line. If you qualify for this plan, you should explore it further. In addition, I also plan to write a future post on HSAs to include utilizing them as a “Stealth IRA”.

2C: Non-Mortgage Debt

Non-mortgage related debts can include anything from student loans, car loans or other consumer debt. When you begin to discuss non-mortgage related debt and where it should fall in a person’s financial priorities, you will not find a consensus. This is because there is such a broad range of factors that may drive your decision to prioritize early debt repayment over other financial goals. This is why personal finance is personal. There is no one size fits all answer. Despite the fact that it is a personal decision, I want to provide a few important factors to consider when assessing whether to pay down debt early.

– What are your goals and desired financial independence timeline? 

Your financial goals and timeline often drive much of your decision making. Do you seek to become financially independent decades before traditional retirement age or do you plan to work until traditional retirement age? Do you have significant financial assets already or are you just starting out on your financial independence journey? If you are reading this blog, you likely are interested in pursuing and reaching financial independence earlier in life. If this is the case, you need to seriously consider your timeline and what makes the most sense while accounting for other factors including those below.

– What is the interest rate on your debt?

The interest rate on your debt is important to understand in order to make a data driven decision. Interest rates as of publication of this post in August 2020 are historically low. You need to consider the cost/benefit associated with early debt repayment when it comes to the interest rate you are paying on the debt vs. the return you could be earning by investing instead. There is an opportunity cost to both. You need to consider and understand this cost.

– How important is the guaranteed return?

Pre-paying debt is a guaranteed rate of return not unlike a savings account, CD, etc. By choosing to pay a debt off early, you are locking in a return equal to the interest you would have otherwise paid. Depending upon your risk appetite, stock market valuations, debt balances and interest rates, it may make sense to take the guaranteed return.

Ultimately, you will have to decide the approach that works for you when it comes to pre-paying debt vs. saving/investing. Again, I should point out that it does not have to be a binary decision. As a HENRY, you can likely do both if you choose. You have to figure out what works for you and then execute your plan remembering that you can always adjust along the way.

Tier 3: Taxable/Children 

3A: Taxable Savings

When it comes to investing in a taxable brokerage account, there is a lot to consider. Here are a couple of reasons one might consider investing in a taxable brokerage account.

• You have contributed the maximum to all available tax-advantaged space and you have extra money you want to save for long-term goals including financial independence and/or early retirement. You may also be consciously choosing not to take advantage of all tax-advantaged space resulting in extra money you want to save for long-term goals.

• You have contributed the maximum to all available tax-advantaged accounts for an extended time period and you want to diversify some of your investment assets to prevent a potential “tax bomb” created by RMDs. This is especially true of high earners that are self-employed or have access to a lot of different tax-advantaged accounts (i.e. 401k, 403b, 457b, spousal accounts, etc.).

• You plan to leave the workforce prior to traditional retirement age and you need sufficient funds to bridge the gap to traditional retirement. You may also plan to use a Roth Conversion Ladder and seek to fund the 5 year gap associated with this strategy.

As a HENRY in the pursuit of financial independence, you will likely find yourself in a position to begin investing in a taxable brokerage account. You may already be doing so. I will do many posts in the future diving into taxable investing, tax efficiency, the importance of costs, active vs. passive management, managing your own investments, index investing, etc. All of these points are critical to understand when choosing to invest to include investing in a taxable brokerage account. However, for today’s post, I think the key point is understanding that if you are a HENRY seeking to achieve financial independence, this will likely be a tool in doing so.

3B: College Education Savings for Kids

When flying on a plane, what is the first thing that flight attendant tells you during the safety briefing? Ensure you put your mask on first before attempting to assist anyone else including your child or children. After all, if you become unconscious first, you will be of little help to anyone else. This is a good analogy when considering if and how much to save for your children’s college education fund. You must ensure that you are adequately funding your financial independence and/or retirement prior to funding your kids college education. After all, you and/or your child can easily get student loans if absolutely necessary. Retirement loans are a different story.

As a HENRY, you may be able to save for both your financial independence and your children’s college education if you choose to do so. However, you may be in a position that you must choose between fully funding your kids college education or achieving financial independence earlier in life. This decision is deeply personal and there is a lot to consider based upon your personal situation. For that reason, I am not going to provide any recommendations. I simply want to point out that there are many options available for funding college and that you should consider them all. Personally, I have chosen to focus on my pursuit of early financial independence and plan to cash flow my children’s college. I also want my children to share some of the burden of paying for college so they have some skin in the game. This is my decision. It does not have to be your decision. You have to figure out what works for you and your family. The key is understanding and assessing the options based upon your particular situation, making a plan and then executing that plan. 

Tier 4: Mortgage Debt

This is another area where you will not find consensus. On one end of the spectrum you have proponents of paying off all debt including your mortgage. Sometimes this is even prioritized over long term saving and investing. On the other end of the spectrum, you have proponents of paying off your mortgage over the full life of the loan so that you can take advantage of the tax deduction and invest your money in an alternate manner resulting in a greater return. You then have all the in between.

Prior to finding financial independence, I never really considered where pre-paying my mortgage landed relative to my financial goals. It likely would have been low on my hierarchy of financial goals. Since finding financial independence, I have read a lot on the subject and I have considered this in great detail. After doing so, I can tell you that pre-paying my mortgage is still low on my hierarchy of financial goals. With today’s interest rates, it does not make sense to me to prioritize paying my mortgage when I have other lofty financial goals. Yes, by pre-paying my mortgage carrying a 4% interest rate, I would be guaranteeing myself a 4% rate of return. However, if I look at the opportunity cost associated with forgoing investment returns on that money, I believe I am better off investing the money. If you recall from an earlier post, the stock market has historically returned and average of 10% annually, before inflation. That is why I recommend you first focus on your other financial goals first. This is especially true in your 20s, 30s and 40s when time is on your side and you can take advantage of compounding to a greater degree. Once you are well on your way to financial independence, you can begin building into your goals to pay off your mortgage early so that you can be truly debt free. 

6 – 12 Month Emergency Fund

As a HENRY your expenses are likely high. In addition, you may be highly compensated or work in a position or industry that is very specialized. In the event of a sudden and unexpected job loss, you could be in trouble real quick. For this reason, I believe it is very important to have an adequate emergency fund that accounts for your above average income, expenses and career risk. This is why I recommend that all HENRYs should seriously consider a 6 – 12 month emergency fund. As a HENRY, you should be able to build a 6 – 12 month emergency reserve if it is right for you. If you ultimately decide that you should have a more significant emergency reserve, I would prioritize this somewhere between Tier 2 and 3.

So… What About Everything Else?

You may be thinking at this point… what about everything else? What about saving for a new home? What about that new car? What about a second vacation home or rental property? What about that boat I have always wanted? As a HENRY, these are all perfectly acceptable areas to spend your money if it aligns with your values and brings you a measurable return on your happiness. 

I did not include these in my financial goal hierarchy because I consider these to all be a part of living. Will you have to save for a new home, car or vacation home or at least budget for it to have the necessary cash to make the purchase? Of course you will. For that reason, you will still have to account for these in your planning and financial goals. However, you need to consider these purchases in the context of where you are on the hierarchy. As a HENRY, I hope that you have Tier 1 covered. If you do not, you likely should not be considering any large purchase like a new home or car. You need to get the basics covered first. Most HENRYs are likely somewhere along the spectrum between Tier 2 and Tier 4. It is in this space that you can evaluate large purchase decisions based upon your financial goals to include when you want to achieve financial independence. As I have said before, I am not willing to sacrifice my quality of life to achieve financial independence and I am not advocating that you do so either. Through intentional action, you can ultimately save for a better tomorrow while still living your best today. You can go from a HENRY to FIRE.

Regards,

– Henry

————————————————————————————————————————————-

Henry’s Personal Highlight:

Prior to discovering personal finance and financial independence, I had most of Tier 1 covered to include the 3 month emergency fund and I was taking full advantage of my employer match. As someone who understood the importance of saving for retirement at an early age, I was also taking advantage of my retirement accounts early in my career (Tier 2). However, the areas where I was doing well were largely offset by areas where I could improve including:

• I often carried a credit card balance of a ~$3,000 – $5,000. Although, I did not make minimum payments, I often carried the debt month to month to continue to fuel impulse purchases.

• I had six figures in student loan debt (many at unfavorable interest rates) and I had no real plans to pay if off early because “everyone has student loan debt”.

• I had car loans and other non-mortgage debt including low interest loans for furniture, etc.

• Despite leveraging my available retirement accounts, I was not taking full advantage by contributing the maximum available.

• I had no clue what a Roth IRA or HSA was or how it could be used.

• I was not investing in a taxable account because quite frankly I didn’t have extra money to invest and I was intimidated by the entire concept.

Once I discovered financial independence and took a deeper dive into investing and personal finance, things are no longer the same. I no longer carry high interest debt. I contribute the maximum to all of my available retirement accounts and take advantage of a Roth IRA for myself and my spouse. I have eliminated all of my non-mortgage related debt with the exception of one car loan with a low balance and favorable interest rate. I save additional money each month in my taxable brokerage account and I have partly funded my children’s education savings accounts. In the midst of my pursuit of financial independence, I am still saving for large purchases that are important to me and continue to spend money to fund the lifestyle that makes me happy. In short, I am saving for a better tomorrow while still living my best today.

References:

[1] https://www.cnbc.com/2019/01/23/most-americans-dont-have-the-savings-to-cover-a-1000-emergency.html

[2] https://www.nerdwallet.com/blog/average-credit-card-debt-household/

[3] https://www.creditcards.com/credit-card-news/rate-report/

[4] https://www.businessinsider.com/personal-finance/how-much-money-americans-saved-every-age

[5] https://www.businessinsider.com/personal-finance/average-401k-balance